Weeping in Private

By Eric J. Fry

When the going gets tough, the tough weep in private…well
hidden from public view. Prior to yesterday’s spectacular
rally, your New York editor had been hearing of many
"rugged," seasoned hedge fund managers who had been crying
into their vichyssoise…both about the stock market’s
abysmal performance in 2005 and about the stock market’s
abysmal prospects for the balance of 2005.

We’d love to offer some solace, but we’d just be faking
it…as we neither empathize with this well-heeled crowd,
nor believe that the market will offer any continuing
relief to investors.

As regular readers may recall, your New York editor had
been anticipating a possible "springtime rally." The rally
finally arrived yesterday, as the Dow vaulted more than 200
points higher to 10,218. (To spare our dignity, we will
ignore the fact that the Dow had tumbled about 400 points
while we were awaiting the springtime rally). Yesterday’s
pyrotechnics on Wall Street certainly broke up the monotony
of steadily falling share prices, but we are reluctant to
believe that a new, enduring bull trend is now underway.

"After [last] week’s breakdown," observes the seasoned
market technician, John Murphy, "there can be little doubt
that the cyclical bull market that started in October 2002
has ended. The question now is how far can the market
drop…There’s a support level at [the stock market’s] late
October low. But I think the S&P (and the other major
averages) are headed all the way back to their August

We are inclined to believe him. We recant, therefore, our
earlier faith in a springtime rally and now profess
complete agnosticism – albeit an agnosticism tinged with
skepticism. In other words, we don’t know what to look for
next. But if we were forced to choose, we’d look for
something bad. In short, we must admit that we are feeling
more fear than greed.

The current market environment, by virtue of its high
volatility and erratic trading action, verily begs to be
abandoned. Therefore, standing aside seems like a
reasonable idea. Timorous investors (i.e. — those who
prefer keeping their money to losing it) do not lack for
reasons to check out of the market and begin the summer
vacations very early this year, like on April 22nd, for

We’d like to maintain our faith in a springtime rally, but
a couple of items war against that inclination. For
starters, one of the market’s most important leaders, IBM,
has "broken down." How else would one describe 14 straight
down days? As we noted in yesterday’s column, what’s bad
for IBM is usually very bad for the stock market as a

To "wax technical" for a moment, IBM is not the only
important stock, or stock market sector, with a "broken
chart." The S&P 500 tumbled below both its 50-day and 200-
day moving average on very heavy volume, although this
high-profile benchmark did mange yesterday to claw its way
back above the 200-day moving average. Unfortunately, the
Nasdaq still languishes well below both its 50- and 200-day

A second unnerving aspect of the current market environment
is the fact that bearish sentiment on Wall Street might not
be as bearish as advertised. It’s true of course, that
numerous gauges of investor sentiment had been registering
high levels of fear, which, as a contrary indicator,
suggested that a rally might soon develop. We cited such
evidence in support of our springtime-rally thesis.

However, yesterday’s advance has already succeeded in
erasing most of those extreme sentiment readings. In other
words, the bulls were merely hiding out in bear’s clothing
for a while. What’s more, most of the bearish sentiment
surveys and indicators failed to reach climactic extremes.
That is, they failed to reach levels that have coincided
with major market lows of the past.

For example, the VIX Index of option volatilities jumped a
few points last Friday when the market dropped 200 points –
an indication that option buyers were becoming more
fearful. But it dropped immediately back to its lows during
yesterday’s rally. In the context of the last two years, as
the chart below illustrates, last Friday’s bounce in the
VIX might seem meaningful…

But when viewed in a longer-term context, we see that last
Friday’s reading on the index still placed the VIX well
within the levels from which SELL-OFFS usually occur, not
rallies. Yesterday’s closing VIX reading was 14.41 – or
several points below the levels that presaged the severe
market sell-offs of mid-2000 and early 2002.

Net-net, greed remains a much more prevalent emotion than
fear…and that’s not usually a good thing for the stock
market. The hedge-fund crowd may be popping champagne corks
over yesterday’s rally, but we’d suggest they keep their
handkerchiefs close by…just in case the going gets tough
again soon.

Portfolio Protection

Did You Notice…?
By Eric J. Fry

If yesterday’s rally was merely a happy interlude in the
midst of a new bear market, what is the individual investor
to do? Our reflexive – and perhaps best – response to the
question is, who knows?

History suggests that cash is the all-season asset of last
resort during stock market sell-offs. And we would not dare
to argue with history. But municipal bonds might provide a
somewhat sexier alternative.  After all, what says "sexy"
better than a muni bond?

We have not become bond bulls – heaven forbid – but we have
become temporary stock market chickens. As such, bonds
might "catch a bid" for a while if/as/when the stock market
resumes its downturn.

The nearby chart illustrates the inverse correlation
between the S&P 500 and "LEO," a closed-end municipal bond
fund. That is, when stocks fall, muni bonds tend to rise,
and vice versa. [Editor’s note: We are not recommending
LEO, merely presenting its price history to illustrate its
historic inverse correlation with the stock market. We know
next to nothing about LEO].

If stocks fall or stay about where they are, buying muni
bonds in some form will prove to have been a good idea.
Let’s consider the math: If you’re an "average" investor,
you’re down 5% year-to-date, just like the S&P 500.
Therefore, if you purchased muni bond funds yielding about
6% tax-free, and bond prices did not move, you’d exit the
year about flat. You’d have a 5% taxable loss on your
stocks and about 4% of tax-free income on your munis. If,
by sheer good fortune, bonds rallied a bit, you’d exit the
year with a small profit. And if the stock market tumbled
while you were clipping your coupons, you’d feel like a

On the other hand, if the stock market pulled out of its
slump and continued rallying, bond prices would probably
fall and you’ll feel like a double dummy.

We hope that helps.

Small Stocks, Big Trouble

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